A tokenized fund is mostly the same as the funds as we know it, with one small, but impactful difference.
It’s a fund – but the shares are on the blockchain.
A tokenized fund is a type of investment fund that uses blockchain technology to issue tokens that represent ownership in the fund. These tokens are digital assets that can be bought, sold, and traded like other cryptocurrencies.
Where we began
Share certificates – At my first auditing job we were sent into the secretarial department that looked like the library in Hogwarts. Ever company had paper share certificates that represented their shares. Holding a physical share certificate was the one and only proof that you were the owner of the sole share in a proprietary limited company. What if that piece of paper disappears? What if the Dementors in Harry Potter burns down the castle? How would we proof our stake in the company?
Then people started realizing that it’s not logical to have paper share certificates anymore.
Along comes the era of the digital certificates and registers of shareholders. Aunt Suzie at the registered office or fund administrator will receive a subscription document and make an entry into a computer program to reflect that I bought shares in the privately owned company. But this is prone to human error, what if Suzie inserts my shares reflecting a 1000 instead of 100. Well, not only have I become richer on paper, but the error also has to be identified and manually corrected. What is auntie Suzie inserts my shares under the name Jane Doe, would I technically not own shares? Digital shareholder certificates solved a lot of the drawbacks that paper share certificates had but had a different set of weaknesses.
Finally, Satoshi Nakamoto created the public distributed ledger. Along comes the era of blockchain. Now we are able to buy a “share” in a company on the blockchain, there is not manually intervention, and nobody can remove my name from the register, except me.
This means that a fund does not need to employ auntie Suzie to keep the register of shareholders up to date. The Blockchain will automatically do that in the back end.
In a tokenized fund, your share in the fund is represented by holding the fund’s unique token in your wallet. You have control over the token and effectively are the owner of a “share” in the fund. This is all secured and checked by blockchain technology making it easy to rely on the number of tokens issued and list of wallets that hold these tokens.
Digging a little deeper
A fund can mint their own tokens. The tokens can be on a blockchain of their choice, and they can specify the naming conventions for the token contract and tokens if the symbol is available. The tokens that the fund mints will represent shares in the fund – holding one token would basically equate to holding a traditional share. This is the same as holding a share certificate or digital certificate – you are holding equity in the fund.
Shareholder in the fund would buy tokens in the fund, transfer their fiat or compensating cryptocurrency amount to the fund, and in return the fund would transfer the fund’s tokens to investor’s wallet.
There is two ways that a tokenized funds mechanics can work that guides how subscriptions are made, and transfers are completed. The first option is having auntie Suzie manually transfer the tokens and the second is using smart contracts to automatically transfer the tokens.
Where the subscription and transfer processes are performed by a smart contract, the contract ensure that the transaction achieved certain requirements before transferring the token to the investor. This is programmed into the contract meaning certain requirements such as KYC and wallet ownership testing have to be performed before any tokens will be transferred. Further eliminating the risk of manual errors or none-compliance.
The list of wallets holding the token can be viewed at any point in time by using a blockchain explorer or service provider to pull the data. The identities of the wallet holders are however only known by the fund and fund administrator preserving the privacy of investors.
Additionally smart contracts can be configured to only allow transfers to approved KYC’d wallets decreasing the risk of secondary market transactions or individuals that have not been KYC’d holding tokens.
As the blockchain is immutable, you can’t change that ownership of the fund without transferring the tokens and the token holder will have to approve any transfers. Auntie Suzie will not be able to insert incorrect information as all the information is processed by way of the blockchain and smart contracts.
Where tokenized funds do not utilize smart contracts, a fund will use increased manual intervention to transfer the tokens and complete the checks to ensure the transaction checked al the required boxes, hence some of the risks of a digital share certificate creeps in again.
One key benefit of tokenized funds is that they allow for fractional ownership, meaning that investors can buy a small percentage of the fund rather than having to invest a large amount of money upfront, unless this is prohibited by the PPM or smart contract that governs the fund.
Tokenized funds offer a level of transparency and accountability that traditional investment funds may lack, as the blockchain technology used to issue and trade the tokens provides a public ledger of all transactions.
What’s the catch?
It’s important to note that investing in tokenized funds does come with some risks, including the potential for price volatility (typical to digital assets) and potential for fraud.
If the tokenized fund is using smart contracts to regulate the token issuance and transfer, there are a couple of extra hoops to jump through to develop the smart contract and ensure that all the jurisdictional laws are incorporated in the workings. A smart contract audit is highly recommended.
The fund will always need developers to assist with change the smart contract or override the procedures if anything out of the usual scope is required.
Fund administrator will need access to normalized data of the fund’s blockchain to be able to process the blockchain transactions in their traditional software, which could be challenging for administrators that are not digitally inclined or do not use capable service providers.
Regulators are not always familiar with the technical benefits and operational procedures of tokenized funds and may require additional information and ask clarifying questions delaying the process to launch.
As Hash was part of the launch of the first fully regulated tokenized fund in the Cayman Islands, we have a unique perspective on the requirements to successfully launch such a fund.
It is a specialized field with added technical complexity, that requires special skills and technical knowledge in the blockchain industry. If directors are not familiar with the technology, it can be challenging to navigate the investment process and management of the fund, leading to potential crucial mistakes.
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